CRS Report on Private Activity Bonds

[1] The federal tax code classifies state and local government bonds as either governmental bonds or private activity bonds. Governmental bonds are for projects that benefit the general public and private activity bonds are for projects that primarily benefit private entities. Generally, the interest on governmental bonds is exempt from taxation whereas the interest on private activity bonds is not tax-exempt.

[2] The federal tax code allows state and local governments to use tax-exempt bonds to finance certain projects that would be considered private activities. The private activities that can be financed with tax-exempt bonds are called "qualified private activities." Because Congress is concerned about allowing tax-exempt bonds to be used for private activities, it uses an annual state volume limit and restricts the type of qualified private activities that qualify for tax-exempt financing.

[3] Although this report does not include a comprehensive economic analysis of tax-exempt private activity bonds, the report does provide some background on the reasons for the federal limitation on tax-exempt bonds for private activities. In addition, this report explains the rules governing qualified private activity bonds, describes the federal limitations on private activity bonds, lists the qualified private activities, and reports each state's private activity bond volume cap.

[4] Since private activity bonds were defined in 1968, the number of eligible private activities has been gradually increased from 12 activities to 19. Also, the state volume capacity limit has increased from $150 million and $50 per capita in 1986 to the greater of $225 million or $75 per capita in 2002. Because of the $225 million floor, most small states are allowed to issue relatively more private-activity bonds (based on the level of state personal income) than larger states.

[5] For more on tax-exempt bonds generally, see CRS Report RL30638, Tax Exempt Bonds: A Description of State and Local Government Bonds. This report will be updated as legislative events warrant.

 Contents

[6] State and local governments issue debt for most large public capital projects such as new schools, public buildings, and roads. On occasion, state and local governments will issue debt for projects whose purpose is less public in nature, such as privately owned and operated multifamily residential housing. Nevertheless, these projects are often afforded the same tax privilege as debt issued for strictly government owned and operated projects. Congress limits the use of tax-exempt bonds for private activities because of concern about the overuse of tax-exempt, private activity bonds. The tax-exempt bonds issued for qualified private activities are limited by the type of activity financed and the volume of debt used for such activities.

[7] Background. The federal tax code classifies state and local government bonds as either governmental bonds or private activity bonds. Generally, the interest on state and local governmental bonds is exempt from taxation whereas the interest on private activity bonds is not tax-exempt.¹ However, the federal tax code allows state and local governments to use tax- exempt bonds to finance certain projects that would otherwise be classified as private activities.² The private activities that can be financed with tax-exempt bonds are called "qualified private activities."³

[8] The current tax exemption for qualified private activities has evolved over time and cannot be traced to a single legislative action or Supreme Court decision. However, two events critically shaped the current treatment of private activity bonds. In 1968, Congress passed the Revenue and Expenditure Control Act of 1968 (P.L. 90-364) which established the basis for the current definition of private-activity bonds. After persistent challenges to the right of the federal government to restrict state and local government debt following the 1968 Act, the Supreme Court agreed to hear a case in 1988 that changed the nature of the federal tax treatment of state and local government debt. In that case, the State of South Carolina challenged the Tax Equity and Fiscal Responsibility Act of 1982 (P.L. 97-248). The 1982 Act required that state and local government debt must be registered.⁴ The registration requirement was viewed by the states, South Carolina in particular, as an unconstitutional intrusion on the ability of states to issue debt. The Supreme Court held that the registration requirement for non-federal government debt was constitutional. In somewhat of a surprise to observers at the time, the Court went beyond the registration ruling and also held the following:

[10] Issues for Congress. As noted above, Congress uses two primary means to restrain the use state and local debt for private activities: an annual state volume limit and restrictions on the type of qualified private activities. The private activity bond volume limit, which originated in the Deficit Reduction Act of 1984 (P.L. 98-369), was implemented because "Congress was extremely concerned with the volume of tax-exempt bonds used to finance private activities." ⁷ The new limit and the list of qualified activities were modified again under the Tax Reform Act of 1986 (TRA 1986, P.L. 99-514). At the time of the TRA 1986 modifications, the Joint Committee on Taxation identified the following specific concerns about tax-exempt bonds issued for private activities:⁸

• the bonds represent "an inefficient allocation of capital";

• the bonds "increase the cost of financing traditional governmental activities";

• the bonds allow "higher-income persons to avoid taxes by means of tax-exempt investments"; and

• the bonds contribute to "mounting [federal] revenue losses."

[12] The greater volume of tax-exempt private activity bonds then leads to the second Joint Committee on Taxation concern, higher cost of financing traditional government activities. Investors have limited resources, thus, when the supply of tax-exempt bond investments increases, issuers must raise interest rates to lure them into investing in existing government activities. In economic terms, issuers raising interest rates to attract investors is analogous to a retailer lowering prices to attract customers.

[13] The final two points are less important from an efficiency perspective but do cause some to question the efficacy of using tax- exempt bonds to deliver a federal subsidy. Tax-exempt interest is worth more to taxpayers in higher brackets, thus, the tax benefit flows to higher income taxpayers, which leads to a less progressive income tax regime.

[14] The revenue loss generated by tax-exempt bonds also expands the deficit (or shrinks the surplus). A persistent budget deficit ultimately leads to generally higher interest rates as the government competes with private entities for scarce investment dollars. Higher interest rates further increase the cost of state and local government projects.

[15] Supporters of tax-exempt bonds for private activities counter that the benefit from tax-exempt bonds exceeds both the explicit (the revenue loss) and implicit (the inefficient allocation of capital) costs of the tax-exemption.

[16] The debate surrounding use of tax-exempt bonds will continue well beyond the current Congress. Proponents and opponents of tax-exempt bonds generally, and private-activity bonds specifically, both explore methods of modifying the rules for private-activity bonds to advance their respective positions. Because the rules and definitions for private-activity bonds are complex, uncertainty about the potential effects of the proposed modifications to those rules is common. This report will not attempt to either justify or criticize the existence of or use of tax-exempt private activity bonds.⁹ Instead, the report provides a brief review of bond fundamentals and a more detailed examination of the rules and definitions surrounding private activity bonds to help clarify the impact of the of those modifications.

Fundamentals of Private-Activity Bonds

[17] Interest Rates on Tax-Exempt vs. Taxable Bonds. Tax-exempt bonds for governmental purposes and for qualified private activities are special because, unlike corporate bonds or U.S. Treasury bonds, the bond buyer does not have to include the interest income from the bond in federal gross taxable income.¹⁰ The bond buyer is willing to accept a lower interest rate because the interest income is not subject to federal income taxes. The lower interest rate arising from the tax-exempt status subsidizes state and local investment in capital projects. For example, if the taxable bond interest rate is 7.00%, the after-tax return for a taxpayer in the 35% income tax bracket who buys a taxable bond is 4.55%. Thus, a tax-exempt bond that offers a 4.55% interest rate would be just as attractive to the investor as the taxable bond, all else equal. For more on tax-exempt bonds, see CRS Report RL30638, TaxExempt Bonds: A Description of State and Local Government Debt.

[19] Figure 1 plots the interest rate of corporate bonds and tax-exempt municipal bonds of like maturity for 1980 through 2001. Bonds issued by state and local governments are usually called "municipal bonds" by the investment community. Generally, the two rates move in tandem, with the taxable corporate bond interest rate always higher than the tax-exempt municipal bond interest rate.

[20] Tax-Exempt Bonds and the AMT. Unlike tax- exempt government purpose bonds, the interest income from tax-exempt private activity bonds is included in the alternative minimum tax (AMT) base. The AMT is a tax that is levied in parallel with the income tax and is intended to ensure that taxpayers with many deductions and exemptions pay a minimum percentage of their gross income in taxes. Because private activity bonds are included in the AMT the bonds usually carry a slightly higher interest rate (approximately 0.5% higher) than do tax-exempt government purpose bonds, all else equal.¹³13 However, the private activity bond rate is still lower than the taxable bond rate. For more on the AMT, see CRS Report RL30149, Thev Alternative Minimum Tax for Individuals.

[21] Repealing the AMT or exempting some bonds issued for qualified private activities would increase investor demand for those bonds. The increased attractiveness of those bonds would eventually lead to lower interest costs for the issuer of private activity bonds.

[22] Technical Definition of Private-Activity Bonds. A private activity bond is one that primarily benefits or is used by a private entity. The tax code defines private business (or private entity) use as ". . .use (directly or indirectly) in a trade or business carried on by any person other than a governmental unit. For purposes of the preceding sentence, use as a member of the general public shall not be taken into account." ¹⁴ Two conditions or tests are used to assess the status of a bond issue with regard to the private entity test. Satisfying both conditions would mean the bonds are taxable private-activity bonds. Bonds are private activity bonds and not tax-exempt if both of the following conditions are met:¹⁵

• [use test] more than 10% of the proceeds of the issue are to be used for any private business use,. . . [and]

• [security test] if the payment on the principal of, or the interest on, more than 10% of the proceeds of such issue is (under the terms of such issue or any underlying arrangement) directly or indirectly secured by any interest in (1) property used or to be used for a private business use, or (2) payments in respect to such property. Or [if the payment is] to be derived from payments (whether or not to the issuer) in respect of property, or borrowed money, used or to be used for a private business use.

[24] What Are the Qualified Private Activities? A number of qualified private activities are granted special status in the tax code (see Table 1). These activities are called "qualified private activities" because they qualify for tax-exempt financing even though they would likely "pass" the two part private activity test which would otherwise disallow tax-exempt financing. The list of qualified private activities has gradually expanded to 19 activities from the 12 that were originally defined by the Revenue and Expenditure Control Act of 1968. The Tax Reform Act of 1986 kept most of the activities listed in the 1968 Act and reorganized the private- activity bond section of the federal tax code.

[25] The Revenue and Expenditure Control Act of 1968. The 1968 Act legislated that the interest payments on industrial development bonds (IDBs, the original private-activity bonds) were to be included in taxable income. This was a shift from the previous Internal Revenue Service (IRS) position, which held that the interest on these bonds was not taxable income. The motivation behind the change offered in the 1968 Act was based ". . . on the theory that industrial development bonds described in the proposed [IRS] regulations were not 'obligations of a State or any political subdivision' within the meaning of section 103 since the primary obligor was a not a State or political subdivision."¹⁶ The 1968 Act also (1) established the basis for the current private use and private security tests; (2) created exceptions to the taxability provision for small issuers; (3) and specified a group of private activities that would qualify for tax-exempt bond financing.

             Table 1. Qualified Private Activities

[27]IRS Review of Tax-Exempt Status. The IRS often reviews the tax-exempt status of outstanding bonds issued for qualified private activities. If the bonds that were originally issued as tax-exempt are found to no longer qualify (meaning that they pass both the security and use tests) the interest on the bonds becomes taxable. Technically, bond holders are the recipient of the tax benefit and are responsible for remitting forgone taxes to the Treasury when a tax-exempt bond fails to qualify. A retroactive taxability finding means all previous tax benefits to the bond holder would have to be returned to the Treasury. A prospective taxability finding means all future interest payments would be taxable to the bond holder. However, in most cases, the IRS will settle the apparent violation by requiring that the issuer, not the bond holders, pay a monetary penalty and that the issuer change the circumstances that led to the non- compliance finding.¹⁷

[28] What Is the Private-Activity Volume Cap?¹⁸ The federal government has limited the amount of private-activity bonds that states can issue to a subset of the 19 activities listed in Table 1. The third column of Table 1 identifies the 12 activities (of the 19) that are subject to an annual state volume cap. The annual cap was increased from the greater of $50 per capita or $150 million in 2000, to the greater of $67.50 per capita and $187.50 million in 2001, and to the current annual limit of the greater of $75 per capita or $225 million in 2002. For small states, the $225 million minimum provides a more generous volume cap than the per capita measure. Table 2 lists the volume cap amount in 2001 and 2002 for all states and territories and compares the cap to state personal income in 2001.

[29] Of the 12 activities subject to a volume cap, two are treated differently than the others and a thirteenth has a separate cap. First, states are required to count only 25% of the bonds issued for high-speed intercity rail facilities against the annual cap. If the facility is government owned and operated, no cap allocation is required. Second, bonds issued for solid waste disposal facilities are not subject to the cap if the facility is government owned and operated. A thirteenth activity, qualified public educational facilities, are subject to a separate annual cap which is the greater of $10 per capita or $5 million.

[30] The total 2002 bond volume cap for all U.S. states and the District of Columbia is almost $26 billion. California is allowed to issue almost one-tenth of total new volume or $2.6 billion (see Table 2). However, as measured against total California personal income, the new volume is less than the national average. For every $100 of 2001 personal income in California, approximately $0.23 of private activity debt can be issued whereas the U.S. average is $0.46.¹⁹ In contrast, Wyoming, the least populous state, could issue up to $1.39 of private activity debt for every $100 of personal income (see the last column of Table 2).

[31] This disparity arises from the two part volume capacity calculation which provides for a minimum of $225 million, regardless of state population. In addition, states that have total personal income below the national average would also have relatively high debt allowance as measured against personal income. The last column of Table 2 provides a comparative measure of the state-by-state volume capacity based on 2001 personal income.

 Table 2. State Private-Activity Bond Volume Cap, 2001 and 2002

[32] Unused volume capacity can be carried forward for up to three years as long as the state identifies the project for which the cap space is dedicated. Bond capacity that has not been used after three years is then abandoned. Abandoned bond capacity was less than 1% of total available capacity in 2000.

[33] Allocation by Type of Activity. Each state independently determines the allocation of its volume capacity. Table 3 identifies the total cap distribution for private activities in 2000 for all states. The category names used by the Bond Buyer newspaper, the source of the data, differ from the more detailed names for the private activities used in the tax code and listed in Table 1. Nevertheless, the Bond Buyer data roughly reflect the cap allocation preferences of the states and their subdivisions. Note that housing related bond issues consumed approximately 46% of the volume capacity for 2000.

 Table 3. Private Activity Bonds by Type of Activity in 2000

[34] Other Restrictions on Private-Activity Bonds. The use of private activity bonds is also limited by other technical restrictions. In general, loosening the restrictions would allow issuers to reduce administrative and compliance costs. However, the relaxed restrictions would exacerbate the concerns surrounding tax-exempt bonds that were discussed earlier in the report. Following is a list of the more technical rules along with the section in the tax code where the rule appears.

• The maturity of the bonds cannot be greater than 120% of the economic life of the asset purchased with the bonds (26 U.S.C. 147(b));

• less than 25% of the bond proceeds can be used to acquire land (except for qualified first-time farmers) (26 U.S.C. 147(c));

• proceeds of the bond issue cannot be used to purchase existing property unless greater than 15% of the cost of acquiring the property is spent on rehabilitating the property (26 U.S.C. 147(d));

• public approval of bonds, either through public hearing and notice or voter referendum, is required for private-activity bonds (26 U.S.C. 147(f)); and

• issuance costs cannot be any greater than 2% of the bond proceeds (3.5% for mortgage bond issues of less than $20 million) (26 U.S.C. 147(g)).

[35] The history, tax laws, financial properties, and economic effects of tax-exempt bonds are all exceedingly complex and continually evolving. This report is intended to clarify part of the tax-exempt bond labyrinth. Nevertheless, the reader may wish to explore tax-exempt bonds in more depth or from a more general, less technical perspective. The following reading list should equip the reader with a good foundation for pursuit of either objective.

Bruce Davie and Dennis Zimmerman, "Tax-Exempt Bonds After the South Carolina Decision," Tax Notes, vol. 39, no. 13, June 27, 1988, p. 1573.

Peter Fortune, "Tax-Exempt Bonds Really Do Subsidize Municipal Capital," National Tax Journal, vol. 51, no. 1, March 1998, p. 43.

Roger H. Gordon and Gilbert E. Metcalf, "Do Tax-Exempt Bonds Really Subsidize Municipal Capital?," National Tax Journal, vol. 44, no. 4, part 1, Dec. 1991, p. 71.

George J. Marlin and Joe Mysak, The Guidebook to Municipal Bonds: The History, The Industry, The Mechanics (New York: The American Banker/Bond Buyer, 1991)

David J.Ott and Allan H. Meltzer, Federal Tax Treatment of State and Local Securities (Washington, D.C.: The Brookings Institution, 1963).

Judy Wesalo Temel, The Fundamentals of Municipal Bonds, 5th Edition (New York: John Wiley and Sons, 2001).

Dennis Zimmerman, The Private Use of Tax-Exempt Bonds: Controlling Public Subsidy of Private Activity (Washington, D.C.: The Urban Institute Press, 1991).

²The Internal Revenue Service (IRS) uses a two part test to classify an activity as a private activity. This test will be explained in more detail later in the report. Generally, activities are classified as "private" because private individuals and businesses benefit directly from debt issued by the state or local government.

³26 U.S.C. 141 describes requirements for qualified private activity bonds.

⁴Before this Act was passed, state and local government usually issued bearer bonds that paid principal and interest to whomever presented the bond to the issuer (or the issuer's agent, usually a bank). In contrast, a registered bond includes the owner's name on the bond and a change in ownership must be registered with the issuer (or the issuer's agent). For a full discussion of the impact of the South Carolina vs. Baker case on tax-exempt bonds, see Bruce Davie and Dennis Zimmerman, "Tax-Exempt Bonds After the South Carolina Decision," Tax Notes, vol. 39, no. 13, June 27, 1988, p. 1573.

⁵State of South Carolina vs. J.A. Baker, Secretary of the Treasury: Supreme Court of the United States, April 20, 1988. 485 U.S. 505.

⁶ Ibid.

⁷ U.S. Congress, Joint Committee on Taxation, General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984, 98th Cong., 2nd sess. (Washington: GPO, 1984), p. 930.

⁸ U.S. Congress, Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986, 100th Cong., 1st sess. (Washington: GPO, 1987), p. 1151.

⁹For a comprehensive economic assessment of private- activity bonds, see Dennis Zimmerman, The Private Use of Tax- Exempt Bonds: Controlling Public Subsidy of Private Activity (Washington, D.C.: The Urban Institute Press, 1991).

¹⁰The discussion here does not address the effect of state taxes on the tax-exempt debt of other states. For example, taxpayers in Virginia must pay Virginia income taxes on the tax-exempt (exempt from federal income taxes) debt of other states. However, Virginia taxpayers do not have to pay income taxes on interest earned on Virginia bonds.

¹¹Interest rate averages are composites of a variety of bond issues and provide a good benchmark for market interest rates for municipal bonds.

¹²"For example, someone in the 10% income tax bracket would find tax-exempt bonds attractive only if the interest rate were 6.37%. Or, looking at the problem from a different perspective, the marginal tax rate below which tax-exempt bonds are not attractive is 26.69%. Thus, taxpayers in marginal tax brackets below this rate would not find tax-exempt bonds attractive investments because the market interest rate on municipal bonds would be too low.

¹³Jacob Fine, "AMT Spreads on the Rise," The Bond Buyer, July 26, 2000, p. 1.

¹⁴26 U.S.C. 141(b)(6)(A)

¹⁵26 U.S.C. 141(b)

¹⁶U.S. Congress, Conference Committees, 1968, Revenue and Expenditure Control Act of 1968, conference report to accompany H.R. 15414, House Report No. 1533, 90th Cong., 2nd sess. (Washington: GPO, 1968), p. 32.

¹⁷See the following IRS website for more information on tax-exempt bond rulings and findings: [http://www.irs.gov/govts.html]

¹⁸26 U.S.C. 146

¹⁹The states were each given equal weight for the average calculation. The values in the last column of Table 2 were summed then divided by 51.